Using fund distributions to create cash flow

Identifying high quality funds that offer decent income

With most GICs paying less than 2% interest and many fixed income investments expected to return low single digits for the coming year, income seeking investors need to look elsewhere to find any form of meaningful cash flow from their investments. Finding a high quality fund that pays out a decent cash flow without significantly eroding invested capital can be a very daunting task these days.

There are a number of options available such as T-Series funds that we discuss elsewhere in this edition, and the more traditional distributions that many funds and ETFs pay out on a regular basis. These distributions can provide investors with a way to generate ongoing income. Unfortunately, not all distributions are created equally.

There is a perception with some that the distributions paid by mutual funds are similar to the dividends paid by stocks. While they do look very similar, in reality, they are quite different. With a stock dividend, the company is paying investors a share of the company’s after tax profits. However, with a mutual fund distribution, the fund is doing one of two things; passing a tax liability to investors, or giving investors their money back. In fact, it is possible to receive a fairly high distribution and see the fund have a very poor year.

Looking at it another way, the fact that a stock receives a dividend can be quite helpful when assessing the quality of that company. After all, it must be doing reasonably well because if it is to pay a dividend, it must be generating the cash flow and income from which to pay those dividends. With a mutual fund, distributions are the transfer of a tax liability or a refund of invested capital, which provide no insight into the actual quality of the fund.

In other words, one cannot base an investment decision solely on the income that a fund may generate. Instead we must put each fund through the same intensive review process that all funds are put through before making an investment.

In doing this, we have come up with a list of what we consider to be five of the better income producing funds that investors may want to consider for the coming year. In reviewing the funds, certain minimum criteria had to be met. First, the fund had to have at least a five-year track record and its distribution yield had to be greater than 4%. Next, we put the results through our proprietary valuation model and looked to identify the funds which not only offered an attractive yield, but also the ability to not only sustain the distribution going forward, but to also provide some potential for capital gains going forward. By using these criteria, some of the funds that pay significant distributions have been eliminated, as we believe that they will result in significant erosion of capital over the long term.

Source: Fundata

RBC Canadian Equity Income Fund (RBF 591) – Managed by the team of Jennifer McClelland and Brahm Spilfogel, this dividend and income equity fund is one of our favourites largely due to its strong risk adjusted return profile. Investing in a well-diversified portfolio of high yielding dividend paying equities and REITs, performance has been very strong, gaining 14% for the five years ending November 30. During the same period, the S&P/TSX Composite Index gained only 0.7%. Equally impressive has been the downside protection of this fund, falling 19% in 2008 while the broader market fell by 33%. As impressive as this performance has been, we don’t believe it is repeatable, and expect more modest returns going forward. It pays a monthly distribution of $0.09 per unit, which at current prices works out to a yield of approximately 4.6%. Looking ahead, we believe that this level of distribution will not result in significant capital erosion, and even with a more modest return profile, we expect that it will continue to perform well compared with its peer group.

Sentry Canadian Income Fund (NCE 717) – For investors looking for a decent yield and the potential for capital gains, it doesn’t get a whole lot better than this fund. Managed by Michael Simpson and Aubrey Hearn, it pays a monthly distribution of $0.0775 per unit, which works out to an annualized yield of about 5.6%. To achieve this, the fund invests in high yielding Canadian and U.S. equities, with some exposure to trusts and REITs. Recently the managers have been increasing their exposure to the U.S. Performance has been strong finishing in the top quartile in every year since inception, except for 2006 when it landed in the bottom quartile. It is our view that this fund will continue to deliver a decent yield to investors and has the potential to deliver modest capital growth going forward.

CI Signature High Income Fund (CIG 686) – Managed by Eric Bushell and his Signature Team, the fund has the objective of generating a high level of income and long-term capital growth. Looking at the fund’s long-term numbers, it has excelled at both, producing respectable returns, modest volatility and a decent yield. It pays investors a monthly distribution of $0.07 per unit, which works out to an annualized yield of approximately 6.0% at current prices. It holds about half of its assets in corporate and high yield bonds with the balance in high yielding equities including equities, trusts and REITs. We don’t expect that the performance will keep up with the more equity focused offerings on our list, but neither will the volatility. This is mainly due to the higher exposure to fixed income investments in the fund. We also like the fact that the MER is a very reasonable 1.60%. Going forward, we expect modest returns and believe that the distribution is sustainable without significant capital erosion.

Bissett Canadian High Dividend Fund (TML 205) – With its focus on small and mid cap dividend paying stocks and REITs, it is not surprising that it is the most volatile fund on our list. It is managed using Bissett’s disciplined team approach that is based on a bottom up, growth at a reasonable price philosophy that looks for companies that have a history of sustainable growth, and the ability to be able to repeat that growth in the future. Performance, particularly longer-term numbers have been strong. It pays a monthly distribution of $0.055 per unit, but it can vary on quarter end months. At current prices, the yield is 5.3%. In reviewing our expectations for the fund, we expect that this level of distribution is sustainable without significant capital erosion going forward. However, given the funds higher volatility, we would suggest that only those with the tolerance for the higher volatility consider it for their portfolios.